ESOPs need oxygen. Here's how the Budget can throw a tax helpline

Daksha Baxi

Employee Stock Options (ESOPs) have proved to be an economical way to attract, retain and motivate talent, especially when companies cannot pay high remuneration at an initial stage.

This variable remuneration became so popular that not just technology companies but brick and mortar as well as fintech firms lapped it up in a big way. It enables employees to have skin in the game and at the same time allows them to participate in value growth of the employer company.

Tax treatment of ESOPs in India was very favourable till 2006. Under the set-up, if the ESOP plan complied with the government guidelines of 2001 and was filed with the tax department, then tax incidence was nil.

The tax was levied only when shares acquired through options were sold. Upon sale, the gains were characterised as capital gains and taxed accordingly. The difference between the sale price and the exercise price is marked as gains.

Options are nothing but financial derivatives that give buyers the right, but not the obligation, to buy or sell an underlying asset at an agreed-upon price and date.

If the ESOP was not in line with the guidelines, the exercise of options was subject to tax. The difference between the market value of shares and the exercise price was treated as perks and taxed at a rate applicable to salary. As and when the employee sold off the shares, the resultant capital gains faced taxation.

However, over time, changes in taxation law have taken the sheen off ESOPs.

What can be done?

Tax on ESOP or equity-linked compensation should be determined at two stages and the total tax is collected only on sale of shares.

The character of income at each stage is different. (i) At the time of exercise of options when the shares are allotted, the difference between the fair market value (FMV) and the exercise price should be treated as perquisite. The amount of tax payable by the employee is based on the tax rates he or she fits into. However, the actual payment of tax is done only when the shares are sold at the second stage.

(ii) When the shares are sold, the difference between the amount received and the FMV is regarded as capital gains. Such gains are taxed appropriately. So, the total tax payable is the amount determined as perquisite tax under (i), plus capital gains tax under (ii).

This is better than the current system. Though the employee pays perquisite tax, it is payable only when he actually gets cash on sale of shares. This would reduce the need for the employer to provide funding to their employees for exercising stock options. It will also simplify the process of employee participation in creating value for the company. Plus, this will reduce tax uncertainty and litigation.

The  proposition is nothing new to the Income-Tax Act. Such tax payment deferral provision exists in the case of conversion of capital asset into stock-in trade. Technically, it means transfer of capital asset and should be subject to capital gains tax. However, the law mandates that the tax is paid only on the sale of the stock in trade.

The government would do well to consider this template for ESOPs. New manufacturers and startups stand to benefit immensely in attracting talent if the ESOPs turn tax friendly.

In the case of the globe-trotting employee, there needs to be clarity on the incidence of tax. Internationally, it is accepted that perquisite arises in the country where the employee performs her duties.  This may be different from the one where she is located at the time of exercise of options.

Daksha Baxi is Head (International Taxation) at Cyril Amarchand Mangaldas. Views are personal.